Parsing Interest Rates’ Surprise Decline

Something odd happened this year when the Federal Reserve started easing back on the policies that keep interest rates low.

Interest rates moved lower.

The most prominent market rate, the yield paid by the government’s 10-year Treasury note, was 2.7% Friday, down from 3% at the end of December.

Rates could move higher again, of course. Many experts think they will. But experts have predicted higher rates for months and rates have confounded them.

That is important because low interest rates and low inflation are good—in the long run, at least—for just about every kind of investment you can imagine and for world economic growth.

Steady growth with low inflation and low interest rates is “very positive for stocks, very positive for corporate bonds, very positive for high-yield bonds, very positive for emerging markets,” said Ken Volpert, who heads the taxable-bond group at Vanguard Group. Vanguard manages more than $750 billion in bonds and $2.6 trillion overall.

This doesn’t necessarily mean that U.S. or foreign stocks are poised for big gains. Interest-rate declines lately have coincided with economic scares and weak stock performance. But in the longer term, steady, low interest rates and low inflation have been the kind of backdrop that keeps financial markets strong.

The yield of the 10-year Treasury note is watched closely because it serves as a benchmark for other market rates, including those of many mortgages.

When the Fed in January began reducing the billions of dollars in bond buying it had been using to keep rates low, bond mavens widely expected the 10-year yield to move above 3% and head for 3.25% or even 3.5%. It has gone the opposite way.

There are several reasons for this, some of which offer hints about where financial markets and the global economy are headed.

Economic growth: One reason for falling interest rates is that investors have been concerned about weak foreign economic growth for months. On top of that, U.S. economic data have been sluggish this year. Many economists think foreign growth is improving and the U.S. data were distorted by bad weather. The bond market seems to be waiting for proof. Meanwhile, weak world growth has helped keep the various U.S. inflation measures well below 2%. Interest rates are sensitive to inflation, so low inflation has contributed to the low rates.

Demand for bonds: Powerful stock-market gains in recent years have been a boon to institutions such as pension funds and insurance companies. Many have covered asset shortfalls they had from the financial crisis. They are thinking more about protecting their holdings from losses than about needing big future returns. Some are boosting bondholdings as a safe way of generating guaranteed income.

Investors seeking safety, meanwhile, have had three kinds of government bonds to choose from: U.S., German and Japanese. While yields on U.S. Treasurys are low, they are higher than the other two. That has led some investors to shift toward Treasurys, which has pushed up Treasury prices and pushed down yields.

The Fed: The central bank’s success in keeping interest rates low and in stabilizing financial markets has made investors reluctant to second-guess the Fed. With Fed officials repeating that they expect to keep interest rates exceptionally low, even after they allow short-term rates to rise gradually, investors are reluctant to fight the Fed.

Fed policy “may be the most important thing” in holding down rates, Mr. Rieder said.

Mr. Volpert at Vanguard said Fed officials have told him that as long as inflation is low, it means there is slack in the economy. That, in turn, means rates need to stay lower than normal. Fed officials “will wait a long time to begin increasing rates,” Mr. Volpert said, and he thinks they will continue giving the market clear guidance to that effect.

Technicals:John Kosar, research director at Asbury Research in Schaumburg, Ill., tracks a series of technical indicators that in the past have been good forecasters of interest-rate trends.

Those include buying patterns of commercial futures traders; the behavior of U.S. Treasurys compared with German government bonds; surveys of trader attitudes and demand for exchange-traded Treasury-bond funds. These all are pointing toward lower rates, Mr. Kosar said.

“I’m telling clients that the table is set for a move toward higher Treasury prices and lower rates,” he added.

Messrs. Rieder and Volpert both expect the 10-year yield to move gradually above 3%. But neither thinks it will exceed 3.25% anytime soon. Many would consider a yield around that level, with low inflation, a strong support for economic growth and for stocks.

What could muddy that picture? Two things: inflation or a sudden drop in growth. Inflation could force the Fed to push rates higher, harming stocks and the growth outlook. Weak growth would force the Fed to step up its intervention to stimulate the economy. That could be good for stocks, but would also raise fears about the economy’s ability to grow on its own.

Many money managers are hoping to avoid both of those problems.

“I think we are going to be in a low-yield environment for a long time,” Mr. Rieder of BlackRock said.